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Mainland loan guarantors have found themselves ensnared in the woes of the underground banking sector following a fresh wave of bankruptcies around the country.

Creaking under the weight of bad debts, hundreds of guarantee groups would be unable to bear even more, although their services are critical for the economic system and the millions of small firms that provide the majority of the mainland's jobs.

"It is by all means a risky business," said Wang Xiao, a Zhejiang entrepreneur who invests in a loan guarantee business. "An increasing number of loan defaults will soon force us to close down the business."

In Wenzhou, nearly 90 per cent of loan guarantors have failed since the start of the credit crisis arising from the underground banking system, according to the media.

The city, dubbed the capital of China's private businesses, had pinned hopes on the companies offering capital guarantee services to bail out troubled small companies when Beijing allowed it to legalise the underground banks.

"It could become the last straw that breaks the camel's back," said Yan Yipan, the head of law firm Zhejiang Panyuan, which mainly deals with cases related to financing. "Without the loan guarantee services, it will be more difficult for small companies to do business."

Rampant loan-shark schemes in Wenzhou resulted in the collapse of the city's economy, with dozens of underground banking operators and investors either committing suicide or fleeing the country.

The government felt loan guarantors could bridge the gap between cash-hungry businesses and financial institutions. Borrowers without enough collateral could use loan guarantee services to access much-needed funds. The guarantors normally charge 3 per cent of the loan amount as fees.

"Three per cent fee looks good, but a loan default would be equivalent to the total profits made from dozens of deals," Wang said.

At the end of last year, there were more than 8,000 licensed loan guarantors, with most of them focusing on serving small enterprises. The companies had a combined registered capital of 880 billion yuan (HK$1.1 trillion), according to the China Banking Regulatory Commission.

Online consultancy Forward said financing demands from the small firms topped 16 trillion yuan in 2012. Indeed, thousands of illegal loan guarantors have been offering guarantee services for the underground banks in the past decade. In April, a bank run in Sheyang, Jiangsu province, was sparked by the collapse of illegal loan guarantors.

In Guangdong, the financial authorities said more than 30 loan guarantors had failed so far this year, while in Sichuan, the provincial government revoked 12 loan guarantee licences. The problems with loan guarantors would weigh further on a mainland leadership already buffeted by complaints about the way government treats small firms.

"Without the privately owned small businesses, China's economy won't have a future," said Song Weiping, the chairman of developer Greentown China. "They are the babies and they should be looked after carefully."

This article appeared in the South China Morning Post print edition as: